Thursday, June 19, 2008

Nominal Income Targeting or (More Economic) Bust!

Awhile back I made the case that the Fed could improve macroeconomic stability by adopting a nominal income targeting rule. Such a rule would (1) force the Fed to be more vigilant in stabilizing nominal spending while (2) allowing it to avoid the distraction of rigidly following inflation. Nominal spending shocks, after all, are the real source of macroeconomic volatility while inflation is merely a symptom of these shocks. Moreover, inflation can sometimes can be hard to interpret--Is the high(low) inflation due to positive(negative) aggregate demand shocks or negative(positive) aggregate supply shocks?--and as a result monetary policy that targets inflation may make the wrong call. For example, I noted the following scenario earlier:

Imagine the U.S. economy is buffeted with a series of positive productivity shocks that increases aggregate supply. This development would put downward pressure on the price level and set off the deflation red alert sign at the Federal Reserve. Now, in order to keep the price level from falling, the Federal Reserve must act to increase nominal spending. If this change in monetary policy were unexpected, or if there were significant nominal rigidities (i.e upward sloping Short-run aggregate supply curve), the nominal spending increase that stabilizes the price level would also push actual output beyond its natural rate level. Hence, there would be both a sustainable component—the productivity gains—and a non-sustainable component—the monetary stimulus—to the subsequent increase in real output. Moreover, the unsustainable pickup in actual output would occur without any alarming increases in the price level ... The increase in nominal spending could thus create a boom-bust cycle in real economic activity without any of the standard inflationary signs of overheating.

As I have argued elsewhere, I believe the above scenario is a good description of what happened in the U.S. from 2003-2005. But I digress; the key point is that monetary policy should aim to stabilize the cause of macroeconomic instability rather than a symptom of it.

Now some observers will reply that the Fed is not just focused on an inflation target, but also looks at the the output gap as is mandated by law. So in some sense, it may already be close to following a nominal income targeting rule. While there is some truth to this claim, there still appears to be an implicit inflationtarget for the Fed that implies when push comes to shove inflation worries will trump any concerns over full employment. The recent inflation hawk talk by Fed Chairman Ben Bernanke is a case in point; other examples include the deflation scares of 1998 and 2003.

Other observers will argue that even if one concedes the advantages of nominal income targeting there still is the difficulty of implementing it: how does one measure nominal income in real time? My answer is that there are monthly measures of real economic activity--coincident index or industrial production--that can be used in conjunction with a monthly price level measure to estimate current nominal income. At a minimum, there is no reason to believe that nominal income targeting would be any harder to implement than a monetary policy following a Taylor rule, which requires ones knows the hard-to-measure in real time output gap.

The importance of stabilizing nominal spending can be seen in the graph below that plots the relationship between the output gap and nominal spending shocks. The output gap is calculated as the percent difference between actual real GDP and the U.S. Congressional Budget Office’s potential real GDP. The nominal spending shocks series is calculated as the deviation of the year-on-year growth rate of quarterly final sales to domestic purchasers from its preceding 10-year moving average. The data cover the period 1953:Q1 - 2008:Q1.

The scatterplot makes it clear there is a strong, positive relationship between nominal spending shocks and the output gap. As a comparison, I have constructed in the same way an inflation shock series from the PCE price index and plotted it below against the output gap.

These figures indicate nominal spending shocks are more closely related to the output gap than inflation shocks. Given these results, I went ahead and plugged the nominal spending shock and output gap series into a vector autoregression (VAR) to get a sense of their dynamic relationship. Five lags were used in the VAR, which is enough to remove serial correlation from the quarterly data (data already in growth rates so no unit roots). After estimating the model and imposing recursive ordering to identify the structural shocks, I got the following impulse response function (IRF) for the output gap given a 1 standard deviation shock to nominal spending:

In plain English, the above figure shows that the typical shock to nominal spending leads to about a 0.5% increase in the output gap--a positive output gap--that persist for about a year and then begins unwinding. Another interesting exercise is to look at the decomposition of the forecast error from the VAR. This exercise explains how much of the forecast error can be attributed to a certain shock. (It tells us whether the interesting results from the IRF really matter)

Here we see that nominal spending shocks account for about 50% of output gap forecast error, a significant amount. By comparison, if the VAR is reestimated with the above inflation shock series instead of the nominal spending shock series, only about 8% of the forecast error can be explained by the inflation shock. Nominal spending shocks matter greatly!

Now I do want to oversell the findings presented here since they are based on a two variable VAR, but they are highly suggestive that nominal spending shocks are more important to macroeconomic stability than inflation shocks. Hence, monetary authorities should pay more attention to nominal spending. Moreover, stabilizing nominal spending should do better than inflation targeting at preventing the buildup of financial imbalances and asset bubbles for reasons explained here. In short, I am big believer that there would be meaningful gains in macroeconomic stability should the Fed should adopt a nominal income targeting rule.